New Roles for Banks in Algeria
Remarks by Jules Erik J. De Vrijer, Division Chief
Middle East and Central Asia Department
International Monetary Fund
At the US-Algeria Business Council Banking and Finance Symposium
New York, February 3, 2005

This paper should not be reported as representing the views of the IMF. The views expressed are those of the author and do not necessarily reflect the views of the IMF or IMF policy.

Your Excellencies, Ladies and Gentlemen:

I am pleased to be here today to address this distinguished audience on the important subject of this Symposium. Why is the role of banks an important subject? And what roles should banks in Algeria play? I think most people will agree that the main challenge for the Algerian economy is to generate high, sustainable economic growth and to significantly reduce the high level of unemployment. Meeting this challenge requires wide-ranging reforms aimed at developing the private sector and attracting private investment, in order to diversify the economy away from its dependence on the hydrocarbon sector. This is where the banking sector comes in. A well-functioning banking sector can play an important role in channeling resources to the best firms and investment projects, and in contributing to ensure the efficient use of these resources. In my presentation, I will focus on some important steps the authorities could consider to modernize the Algerian banking system so that it can better perform these functions.

Before turning to the Algerian banking sector, I would like to selectively review our knowledge concerning the linkages between the quality of financial intermediation and economic performance. By financial intermediation, I mean the functions which financial institutions and markets perform to mobilize society's savings, efficiently allocate these savings to investment projects, and facilitate transactions. In the second part of my remarks, I will summarize the salient features of banking intermediation in Algeria as we see them. This will naturally lead me to discuss some recommendations for Algerian policy makers on how to improve the quality of banking intermediation. I will conclude with a few thoughts on why it makes sense to allow more foreign bankers to enter the Algerian banking system.

Financial intermediation and the real economy

The linkages between the quality of financial intermediation and economic performance have received a lot of attention in recent years, so much so that financial stability has become an explicit mandate of many central banks. A growing body of experience and empirical research also finds that:

• Economies served by better-developed financial systems tend to grow faster because the private sector in these economies has better access to external finance to fund new investments.1 This effect appears to be more pronounced in countries at lower income levels.

• Better information sharing on borrowers and better protection of lenders are associated with higher levels of credit to the private sector.2

• Lower state ownership of banks is associated with higher growth of per capita income and more developed financial markets.3 Independence of bank management from direct state control is conducive to financial intermediation taking place on a sound commercial basis.

• Opening up the financial system to participation of reputable foreign banks often leads to faster development of financial systems.4

These and other studies strongly suggest that policy-makers should aim at bolstering the quality of financial intermediation by enhancing the role of private banks and reducing the direct involvement of the state in the banking sector. At the same time, it is important to develop incentives for good governance and invest in the information infrastructure for credit, without losing sight of the need for strong supervision to monitor risk-taking and enforce prudential regulations.

Banking intermediation in Algeria

Against this background, where does the banking sector in Algeria stand? In my remarks on this issue, I will use the findings of the Financial System Stability Assessment (FSSA) for Algeria. By way of background, I should say that in the wake of the financial crises in emerging markets in the 1990s, IMF staff has undertaken to assess the financial systems of member countries as part of the regular IMF surveillance of these countries' economies. The assessments are conducted at the request of the member countries and Algeria requested one in 2002. We conducted the work jointly with the World Bank in 2003 and the Algerian authorities consented to publish the FSSA on the IMF's website in May of last year. Furthermore, in its discussion of the report on the last Article IV consultation with Algeria on January 12, 2005, the Fund's Executive Board welcomed the fact that some of the FSSA recommendations have been adopted and called on the Algerian authorities to also implement the other recommendations. Both the report on the 2004 Article IV consultation and the Executive Board Assessment have been published on the Fund's website.5

A key feature of the Algerian banking sector is that, despite the licensing of 15 private banks since 1998, public banks continue to account for 9/10th of financial system assets and are burdened by sizable nonperforming loans to public enterprises. Public banks' losses averaged over 4 percent of GDP each year from 1991 to 2002 and continue to accumulate, albeit perhaps at a slower pace. These losses have not affected system stability because the Treasury has repurchased some of the nonperforming loans. These bail-outs, however, have distorted risk pricing and stunted the development of an appropriate credit culture. To address this issue, the 2005 government budget includes for the first time explicit subsidies to loss-making public enterprises to replace new bank credit. The Minister of Finance has also established a task force to determine residual stock losses and prospective flow losses of public enterprises.

Increasing the health of the banking system also requires improving banking supervision in many core areas. The failure of the largest Algerian private bank in 2003 exposed important gaps in supervision and regulation, and tarnished the public's opinion of domestic private banks. Therefore, we welcome that the Bank of Algeria, with Fund technical assistance, is taking steps to increase its supervisory capacity, including by recruiting and training additional inspectors.

In the past, the passivity of the state shareholder of the largest banks has frustrated attempts at making public bank managers accountable. A recent positive development is that managers of public bank have signed performance contracts for 2004-05 with the Ministry of Finance. Public bank executives we met last year mentioned stronger emphasis on tighter credit risk management and more forceful loan recovery.

Many bankers in Algeria note that small- and medium-sized enterprises are very costly to screen and monitor because firms run several books. A business-friendlier tax regime would help improve the quality of their financial information. Also, sustained economic growth should increasingly provide incentives to small- and medium-sized enterprises to seek outside finance and play by the bankers' rules. In this regard, it is also important that progress is being made towards the implementation of a new accounting system by 2007.

Finally, the modernization of the payment system is moving ahead with World Bank assistance. The real-time gross settlement system is programmed to be operational by end-2005 and a contractor for the retail payment system has been selected last December.

The Road Ahead

When looking at the road ahead, the FSSA mainly recommended to privatize public banks over the medium-term and to improve the operating environment for banks to cut intermediation costs. More specifically, as far as public banks were concerned, our most important advice was to quickly sell the better banks, make shareholder control much tougher on the remaining ones, and fully finance unviable public enterprises through the budget instead of through the public banks. As far as the operating environment was concerned, we advised chiefly to improve accounting and audit practices, make supervision pro-active, and modernize the payment system.

As noted above, the authorities have initiated a number of reforms but much remains to be done to allow the banking sector to better play its role in financing investment and growth. Furthermore, the government has recently sent a confusing signal about its intentions by prohibiting public entities from dealing with private banks. In our view, the key actions for the period ahead would include:

• End the practice of public banks to finance loss-making public enterprises. We welcome the replacement of part of public banks' credit to loss-making public enterprises by government subsidies. These, however, should be framed in a comprehensive public enterprise restructuring plan, with clear guidelines on the relation between public banks and these enterprises.

• Enhance transparency, governance, and competition in the sector by: (i) requiring public banks to only lend to creditworthy clients; (ii) rescinding the recent prohibition for public entities to deal with private banks; and (iii) publishing public banks' performance contracts and ex-post evaluations.

• Significantly intensify efforts to strengthen banking supervision, in particular by improving on-site and off-site supervision of the large public banks, and strictly enforcing prudential rules. We also encourage the authorities to continue to enhance the supervisory capacities of the Bank of Algeria, speed-up the implementation of the new information system for reporting bank data, and undertake risk-based surveillance that ensures effective early warning.

• Formulate an action plan for privatizing several public banks. In this regard, we consider that selling one public bank quickly to a reputable foreign bank would be important for its demonstration effect, including by transferring know-how to the sector, and would help contain the cost of restructuring other public banks.

Concluding Remarks

In recent years, Algeria has succeeded in increasing economic growth while keeping inflation low, and the country's macroeconomic outlook is good. However, progress in structural reforms has been slow with the exception of external trade liberalization.6 The increased political stability and Algeria's strong financial position have now opened an excellent window of opportunity to accelerate the transition to a market economy. The 2005 budget and the economic program of the government for the next five years go in this direction. Given the strategic role of the banking sector in the economy, we encourage the authorities to be more decisive on financial sector reforms. The topics chosen for this Symposium and the fact that senior policy makers are here today suggest that we see eye to eye on this.

In particular, we encourage the authorities to push ahead with their efforts to put the relationship between public banks and public enterprises on a sound footing; significantly strengthen banking supervision; and privatize a number of public banks.

Political stability and macroeconomic discipline will help to convince the banks represented in this room to establish themselves in Algeria. The operations of foreign banks already present in Algeria have reportedly so far been rewarding. However, further progress on financial sector reform is needed to enable banks to fully play their role in enhancing economic efficiency and growth, and in helping Algeria achieve its economic potential. For its part, the IMF will continue, within our areas of expertise, to advise and provide technical assistance to the Algerian policy makers in support of their reform agenda.

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1 Levine, "The Financial Sector and Growth" NBER Working Paper No. w10766, 2004.2 Djankov et al., "Private Credit in 129 Countries," World Bank Working Paper, 2004.3 La Porta et al., "Government Ownership of Banks," Journal of Finance, Vol. 57, 2002; and Barth et al., "Banking Systems Around the Globe," University of Chicago Press, 2001.4 Fries et al., "Cost Efficiency of Banks in Transition: Evidence from 289 Banks in 15 Post-Communist Countries," EBRD Working Paper No. 86, 2004, and Bonin et al., "Privatization Matters: Bank Efficiency in Transition Countries," University of Michigan Business School Working Paper No. 679, 2004.5 There is currently no lending arrangement between Algeria and the Fund, and therefore there is no economic program supported by Fund resources. Fund policy discussions with, and advice to, Algeria are now undertaken mainly in the context of the annual surveillance exercise, also known as Article IV consultation, that the Fund conducts with every member country. This exercise culminates in a discussion and assessment by the Fund's Executive Directors, which constitutes the collective view of the international official community regarding the Algerian economy.6 An association agreement with the European Union was signed in 2002 and negotiations towards accession to the WTO should conclude by end-2005.